The 2017 Corporate Tax Cuts Went to Shareholders
The 2017 corporate tax cuts and the tax break on repatriation of profits from foreign subsidiaries were supposed to increase investment and create jobs. As most economists predicted, corporate profits have soared but few companies have increased investment or created jobs.
Why? One reason is that money has been cheap since the recession. Any reasonably healthy corporation has been able to borrow cheaply. So when the tax cut came along, corporations didn’t have much pent-up desire to make investments. If they had had something they wanted to invest in, they would have already done so.
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A CEO’s (Mythical) Conversation with Himself
So what should I do with all this newfound money? Let’s see, maybe we could raise our workers' wages. Nah, why do that? Hmm, most of my pay depends on our stock's price. I need our stock price to be above the strike price of my options or they're worth nothing. And, since I own a lot of stock, the higher the better.
The fastest, most reliable way to raise the stock price is to buy back our own shares. And I'll be a hero to the shareholders and board, so they'll give me a big bonus this year, too. Wow, this is great.
Share Buybacks Soar
The 2017 corporate tax cuts didn’t start share buybacks; they just whipped them into a frenzy.
Stepping back in time, William Lazonick, writing in Harvard Business Review1, shows that from 2003 through 2012, the 449 companies that were in the S&P 500 index that whole time used 54% of their earnings — a total of $2.4 trillion — to buy back their own stock. As Lazonick goes on to explain:
Why are such massive resources being devoted to stock repurchases? Corporate executives give several reasons ... none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay, and in the short term buybacks drive up stock prices. In 2012 the 500 highest-paid executives ... received, on average, $30.3 million each; 42% of their compensation came from stock options and 41% from stock awards. By increasing the demand for a company’s shares, open-market buybacks automatically lift its stock price, even if only temporarily, and can enable the company to hit quarterly earnings per share (EPS) targets.
As a result, the very people we rely on to make investments in the productive capabilities that will increase our shared prosperity are instead devoting most of their companies’ profits to uses that will increase their own prosperity—with unsurprising results. Even when adjusted for inflation, the compensation of top U.S. executives has doubled or tripled since the first half of the 1990s, when it was already widely viewed as excessive.
Share buybacks soared after the tax cut became effective in 1Q18, rising to a record $823.2 billion for the year ending March 2019, up 43.1% year-over-year2. On a calendar year basis, 2018 share buybacks were up 55% over 2017. Share buybacks reached new record highs in every quarter of 2018. In 2019, the buyback frenzy is abating, but remains at record levels.
Dividends Are Up Too
You might think that maybe share buybacks are up so much because companies cut back on returning money to shareholders via dividends. Nope! In 2018, dividends among the S&P 500 were up almost 9% over 2017.
Total Yield is Way Up
Another way to look at the effect of the tax cut it to look at the total return to shareholders of share buybacks and dividends combined. Total yield among the S&P 500 in 2017 was 4.12%, jumping to 6.01% in 2018, a whopping 46% increase.
Business Investment Increased a Little
The increase in share buybacks and dividends after the tax cuts doesn’t necessarily imply that business investment didn’t increase too. It did.
According to the Federal Reserve3, gross private domestic investment, which is a measure of investment by private businesses, went from $3.37 trillion in 2017 to $3.63 trillion in 2018, an increase of just under 8%. (Note that these Federal Reserve numbers include all businesses, not just those in the S&P 500.)
Putting It In Perspective
To put it in perspective, combined return to S&P 500 shareholders from share buybacks and dividend increases increased by 46% from 2017 to 2018, while overall business investment increased less than 8%.
It is also helpful to look at buybacks and dividends among the S&P 500 as a percentage of after-tax earnings. In 2017, buybacks were 55% of earnings and dividends were 45% of earnings. In 2018, buybacks climbed to 72% of earnings and dividends fell to 41% of earnings. Interestingly, in 2018, S&P 500 corporations returned more than they earned to shareholders.
Also observe that these corporations spent more on buybacks than on dividends. Why? Well, first, there’s the effect of buybacks on executive compensation. Second, buybacks deliver wealth to shareholders as capital gains, which, for domestic investors, have significant tax advantages compared with dividends, and, for foreign investors, are untaxed by the US.
What a great deal: The administration gave corporations huge tax breaks arguing that, contrary to economists’ predictions, the tax breaks would increase investment, creating more jobs and wage growth in the future, which, in turn, would lead to increased tax revenues. None of this happened. The economists were right!
The Supply-Side Argument is Wrong
We’ve seen repeatedly that in real life this supply-side argument is wrong. It was wrong when Reagan cut taxes, it was wrong when Bush cut taxes, and it is wrong now.
This might seem counterintuitive, but it is not hard to understand: When taxes are low, company executives take wealth out of their companies and deliver it to themselves and other shareholders, losing little to taxes. Higher taxes discourage taking wealth out of the company because more of the company’s wealth will go to paying taxes.
With higher taxes, the best way to retain corporate wealth is to plow it back into the company, as capital investments, increased R&D, or improved worker pay. Such investments lead to longer-term corporate growth, including more jobs. And, increases in worker pay translate into increased consumer demand, helping further to boost the economy.
The 2017 corporate tax cuts primarily delivered more wealth to the already wealthy and led to little investment in the future of our economy. Instead, they caused the Federal deficit to soar as tax revenues fell while neither boosting the economy nor accomplishing anything of value for the country’s future.
Thanks to Tony Wikrent and Ava Nackman for helpful feedback on an earlier draft.
Laconick W. Profits Without Prosperity. Harvard Business Review. https://hbr.org/2014/09/profits-without-prosperity. Published September 2014.
S&P 500 buybacks decline in Q1 2019 after four consecutive record quarters; still post 2nd highest quarter ever. CISION PR Newswire. https://www.prnewswire.com/news-releases/sp-500-buybacks-decline-in-q1-2019-after-four-consecutive-record-quarters-still-post-2nd-highest-quarter-ever-300873537.html. Published June 24, 2019.
Flow of Funds, Balance Sheets, and Integrated Macroeconomic Accounts. Z.1 Financial Accounts of the United States. https://www.federalreserve.gov/releases/z1/20190920/z1.pdf. Published September 20, 2019.